Investors often overlook SEC filings, and it is the job of the 10Q Detective to dig through businesses’ 8-K and 10-Q SEC filings, looking for financial statement ‘soft spots,'(depreciation policies, warranty reserves, and restructuring charges, etc.)that may materially impact Quality of Earnings.

Monday, September 25, 2006

Hi-Tech Pharmacol--Be Wary of its Name.

Hi-Tech Pharmacal Co.'s (HITK-$13.60), corporate name belies its actual operations. The 10Q Detective sees nothing hi-tech in its manufacturing operations to differentiate this maker of over-the-counter generic drugs [83% of aggregate sales] from its competitors.

Bernard Seltzer and his son, David S. Seltzer, serve as Chairman of the Board Emeritus and as Chairman of the Board, President, Chief Executive Officer, CEO, Secretary and Treasurer, respectively, of the Company.

Bernard Seltzer, who beneficially owns 4.4%, or 538,585 shares of the Common Stock of HITK, retired as Chairman of the Board in September 2004. As Chairman Emeritus (an honorary title that in Latin means “to earn for service”) receives an annual base salary of about $285,000. [Ed. note. Was there ever a time that ex-CEO’s took their retirement packages—including stock options, pension, SERP—and to quote General Douglas MacArthur—“just faded away?”] Mr. Bernard Seltzer may also receive a bonus in the discretion of the Board of Directors.

David S. Seltzer, who beneficially owns 15.4%, or about 2.0 million shares of the Common Stock, has served as President and Chief Executive Officer effective May 1, 1998 (succeeding his father). David Seltzer’s employment agreement provides that his annual base salary is $382,000 for the fiscal year commencing May 1, 2005 through April 30, 2007. David Seltzer earned a cash bonus of $277,000 and $227,000 in FY 2006 and FY 2005, respectively.

Corporate Governance Issues

HITK uses the services of Mr. Reuben Seltzer, an attorney and Director, and the son of the Company’s Chairman Emeritus and brother of the President. He provided “legal and new business development services” throughout the year. For each of the fiscal years 2006, 2005 and 2004, he received fees, auto allowance and health insurance benefits totaling $236,000, $248,000 and $199,000, respectively. He is also the beneficial owner of 9.2%, or about 1.2 million shares of Common Stock of HITK.

In addition, in each of FY 2002 and 2001 the Company granted Mr. Reuben Seltzer an option to purchase 37,500 shares of the Company’s common stock at an exercise price of $5.76 and $2.67, respectively, which have vested and are now exercisable through 2006 and 2005, respectively. During the years ended April 30, 2006 and 2005 the Company valued this option at $237,000 and $130,000, respectively, which was charged to operations.

What a great gig if you can get it? In our view, Mr. Reuben Seltzer is getting paid by HITK to ‘consult them’ on the Company’s investment in Neuro Hi-Tech (NHI) of which Reuben Seltzer is Chief Executive Officer (and receives $165,000 in annual salary).

Neuro-Hitech (NHPI-$6.00) is a biotech start-up focusing on the commercialization of next-generation therapies against proven targets for neurodegenerative diseases. The company's signature offering, Huperzine A, is being tested for efficacy in the treatment of Alzheimer's disease and the company has plans to study other degenerative disorders such as vascular dementia, mild cognitive impairment and myasthenia gravis (as funding permits). Neuro-Hitech is currently developing Huperzine A in both oral and transdermal form.

Huperzine A is a Cholinesterase Inhibitor (AchE inhibitors) that Neuro-HiiTech believes may be effective in the treatment of Alzheimer disease (AD) and Mild Cognitive Impairment (MCI), although, to date, its efforts have been focused upon huperzine A’s effectiveness in AD.

At April 30, 2006, HITK had a 12 percent interest, or beneficially owned 1.13 million shares, in Neuro-Hitech, Inc. In addition, the Company has 15,000 warrants at an exercise price of $5.00 per share.

HITK’s stake in Neuro was profitable to the Company last year. The Neuro-HiTech shares available for sale over the next twelve months at April 30, 2006 totaled 94,115, valued at $744,000 and resulted in an unrealized gain of $439,000, net of deferred tax of $292,000 being included in accumulated other income as of such date (share-net of 3 cents). The restricted shares aggregating 1,031,495 are carried at cost of 13 cents per share!

Additionally, HITK and Reuben Seltzer have a 17.7% and 17.7% interest, respectively, in Marco Hi-Tech JV LLC, a New York limited liability company which markets raw materials for nutraceutical products (principally huperzine). To generate revenue, Marco has imported and sold inventories of natural huperzine (from China) and other dietary supplement ingredients to vitamin and supplement suppliers to generate revenues. [Ed. note. Undisclosed is whether or not HITK buys any raw materials from Marco.]

Two pre-clinical studies suggest that Huperzine A's potential advantages over other AChE inhibitors include higher blood-brain-barrier penetration, better tolerability and multiple mechanisms of action, including both AChE and NMDA receptor antagonism.

The drug is currently in the enrollment stage of a planned multicenter, double-blind, placebo-controlled therapeutic Phase II trial to determine whether treatment with huperzine A 200µg twice a day improves cognitive function in individuals with AD.

We applaud the genuine efforts of NHI in expending the necessary resources in bringing to market neuroprotective agents for cognitive diseases (in a field littered with bankrupt biotech failures).

NHI aside, we are troubled with the corporate governance at Hi-Tech. How can Reuben Seltzer make a material contribution to Hi-Tech when he more than has his hands full running day-day operations and R&D complexities at NHI? And why is Hi-Tech giving him a car allowance and health insurance, too?

Should the Seltzers be feeding self-indulgencies when HITK’s fundamentals are weakening? The Common Stock has tumbled more than 50% in price in the last six months, after the specialty pharmaceutical company posted a share-net loss (8 cents) in the first quarter of 2007 ended July 31, 2006, compared with a profit (of 11 cents) a year ago.

In a conference call with analysts, the company said it faced both new competitors in its existing product lines and stronger pricing competition from existing competitors. Management cited lower demand for its higher margin cough and cold products due to a mild and short-lived cold season as the reason for a decline in unit sales of generic sales to $8.4 million from $13.9 million last year.

Valuation Analysis

In our view, the Company’s Health Care Products, which markets branded products, is positioned for attractive growth. In the 1Q:07, net sales for this division were $1,790,000, an increase of $555,000 or 45%, compared to $1,235,000 reported for the same period last year, fueled by growth in the (arthritic pain relief) Zostrix and the Diabetic Tussin line of products.

A full pipeline is critical for a generic drug company’s success. Management has identified more than $4 billion of brand name drugs in the liquid, sterile, and semi-solid dosage forms that will lose patent protection over the next five years. The Company is currently developing drugs with total branded sales of over $2 billion.

In FY 2006, HITK received Abbreviated New Drug Application for only one drug, Acyclovir Oral (equivalent to GlaxoSmithKline’s Zovirax Suspension) indicated for the treatment of Herpes Zoster Infections, Genital Herpes and Chicken Pox.

Generic companies have pricing power for only six-months, so its all about pipeline and volume (sold units). The US FDA offers a 180-day exclusivity period to generic drug manufacturers. During this period only one (or sometimes a few generic manufacturers) can produce the generic version of a drug. Ergo, It’s deliver—or die—for when competitors enter the market with their own bioequivalent generics, supply goes up, and price (and margin) goes down.

According to management, the Company has 12 products submitted to the FDA and pending approval, and approximately 20 products in various stages of development.

Additionally, HITK should benefit from the new Medicare prescription drug plan.

However, we see no catalyst to jumpstart HITK’s growth engine right now. For FY 2007, Hi-Tech is selling for 23 times analyst estimates of $0.58. Analysts do expect a rebound in FY 2008 and look for EPS growth of 31% to $0.76 per share.

Follow the insiders? In the last six-months, there have been no insider purchases.

Additionally, the growth in short interest implies that investors expect the stock to trend lower, too. From June through August 2006, days to cover have increased from 5.01 to 7.89 days.

The Company does, however, have an attractive balance sheet. Working capital of $62.43 million (less pre-paid taxes), almost $4.00 per share in cash, a book value of $7.23 per share, and no long-term debt.

In our view, management should look to purchase growth instead of wasting money on family enterprises (years away from a pay-off). Hopefully, in complex litigation involving patent disputes, the Company does not use the services of Reuben Seltzer (given his other responsibilities).

The catalyst for a turnaround lies in first-to-market advantage with a blockbuster drug losing patent protection (like the cholesterol drug Zocor or Bristol-Myers’ anti-platelet Plavix).

Unfortunately, in HITK, we just do do not see any hi-tech "sizzle."

Editor David J Phillips does not own any of the stocks mentioned in this article. You can see his portfolio holdings in the sidebar. The 10Q Detective has a full disclosure policy.

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About Me

Prior to founding the 10Q Detective, I held equity analyst positions with three brokerage firms and published the investment newsletter e-Growth Profit Letter - dedicated to uncovering companies with innovative, proprietary technologies in a range of industries. My work has been published in The Dick Davis Digest, The Bull & Bear Financial Report, BusinessWeek, CBS Interactive, Forbes, Kiplingers Personal Finance, MSN Money, TheStreet.com, 24/7 Wall Street, The Wall St. Journal, The International Herald Tribune, and Investors Business Daily.
The 10Q Detective is recommended as a 'Must-Read' money blog in Kiplingers (Oct. 2006 & May 2008), Washington Post (May 2009); a 'Best of Financial Blog' by BusinessWeek (Feb. 2007 & April 2008),a 'Smart Stop' by The Journal of Accountancy (March 2008); 'Top 25' by Time magazine, a 'Top 50 Money Blog' by CurrencyTrading.net (April 2008); and, a 2011 LexisNexis Business Law Blog Nominee.